Corporate Tax Reform and Puerto Rico

Posted January 7, 2018

Some Puerto Rico leaders are claiming unfair treatment for Puerto Rico in the new tax bill. Fully understanding the situation, however, requires us to remember the history of corporate tax deals in Puerto Rico.

It all started with 936.

In 1976, Congress passed Sec. 936 of the Internal Revenue Code to create a tax credit for U.S.-based manufacturers who brought their manufacturing into Puerto Rico. The stated purpose was to encourage job-creating investments in Puerto Rico.

High-tech companies, including pharmaceuticals, found a way to attribute income to Puerto Rico when the work was was actually done in the States. This is done by transferring patents and trademarks that account for much of the value of their products to territorial subsidiaries.This allows companies to avoid paying taxes, but doesn’t bring many jobs to Puerto Rico. It’s really just a matter of accounting.

The corporations got the tax credit, but Puerto Rico didn’t get the jobs. In fact, companies got more than $2.00 in tax savings for every dollar they spent in Puerto Rico. That means it would have cost less for the federal government to create jobs directly — maybe paying workers to update and improve the infrastructure — than it did to provide that tax incentive.

When the federal government saw that Sec. 936 was being abused, they determined to change the law. President Reagan proposed making 936 a credit for wages and President Clinton reduced Section 936. In 1996, the credits were scheduled to sunset as of 2006 because 936 companies were saving much more in taxes than they contributed to Puerto Rico, and the lower taxes were viewed as unfair to companies manufacturing in the States. Former House Budget Chairman Kasich called 936 “the poster child of corporate welfare” as it used Puerto Rico’s poverty to obtain tax savings for companies.

Corporations weren’t ready to give up those benefits. They converted their domestic Puerto Rico operations into foreign subsidiaries (‘controlled foreign corporations’ or CFCs) because CFC income is not taxed unless it is paid to the parent company.

Why a special carve-out for Puerto Rico failed

Exempting Puerto Rico income from the taxes in whole or in part, as some are proposing, would recreate 936 as it existed prior to 1993 and contradict the goal of prevention of tax avoidance. It would also make Puerto Rico the world’s only remaining tax haven since income from foreign CFCs (and from the States) would be taxed.

Puerto Rico’s GDP last year was $105 billion but its GNP – its real economy – was only $70.1 billion. The $34.9 billion difference was CFC income that didn’t circulate in the islands; it was just attributed to the territory on paper. This is an illusion — it doesn’t help Puerto Rico at all.

Microsoft saved $1.5 billion a year in taxes through Puerto Rico in each year from 2009 to 2011. They had only 179 employees in the Islands and paid local taxes of just $41 million a year. The local tax would be $180 million if a company tried to do this now. Still, even $180 million and the cost of supporting 179 jobs are nothing compared to the $1.5 billion savings through tax avoidance.

Since Puerto Rico’s economy fell into depression 11½ years ago, shrinking by a fifth and losing a fifth of its jobs, manufacturing attributed to the territory has grown by a third, to $49.7 billion. This includes manufacturing by taxed domestic companies and by local companies as well as manufacturing by CFCs and is said to be 48% of the GDP — but 70% was really due to production in the States that avoided taxes through CFCs.

Under the new tax bill, CFCs could not avoid taxes anyplace else. Moving away from Puerto Rico and building new facilities in a new location would be costly. Moving would also require additional labor costs. Employing factory workers would be 42% higher in the States than in Puerto Rico. It would cost 37% more for labor in Ireland and it would be only 4% lower in Singapore. Manufacturing in Singapore would also create higher costs in shipping and communication, while significantly lengthening the supply chain from factories to customers.

In any case, if lower wage and environmental costs were the reason to move, the companies would have moved already. Federal tax costs are equal in Puerto Rico and in foreign countries now and would still be equal under the new tax law.

New tax incentives

The Federal government has provided new tax incentives for investment in underdeveloped and distressed communities in the States based on real economic contributions, such as payroll and investments in plants and equipment. Programs of this kind included Empowerment Zones, the DC Enterprise Zone, and the New Markets Tax Credit. Puerto Rico was generally excluded these programs. Representative Paul Ryan and Resident Commissioner Luis Fortuno (R) proposed a new national Enterprise Zones program many years ago that would have included Puerto Rico, but the proposal did not pass.

Congressional tax reform proposals over the years that led up to the legislation enacted in December included measures to tax income that has avoided taxation by transferring ‘intangible assets’ to CFCs. Efforts to get Puerto Rico exempted in each of these plans failed – just as efforts to carve out Puerto Rico from the new tax law failed. The bipartisan, bicameral Congressional Task Force on Economic Growth in Puerto Rico issued a report in December of 2016 that also refused to carve out Puerto Rico to create special tax treatment for corporate manufacturers in Puerto Rico. Support for a special carveout for Puerto Rico manufacturing has clearly lost its luster.

Recognizing which way the political winds were blowing in late 2017, Resident Commissioner Gonzalez-Colon (R-PR) proposed as alternatives either a new Investment Zones program for very low-income communities or extension of 30A to Puerto Rico. Investment Zones benefits would include a tax credit for 40% of payroll, 100% expensing of capital investments, and a capital gains tax exclusion. She has also proposed equality for Puerto Ricans in the refundable portion of the Child Tax Credit. Neither of these proposals was included in the new tax law either.

Devastating tax law changes?

The tax benefits for Puerto Rico were mostly smoke and mirrors, but Puerto Rico Gov. Ricardo Rosselló is concerned that the new tax bill could be devastating to Puerto Rico’s economy. A recent article at The Hill by Manuel A. Laboy Rivera, the Secretary of the Department of Economic Development and. Commerce, claims that “The hurricanes did not destroy Puerto Rico’s strongest economic assets – our people, our resiliency, our location and our incentives.”

In fact, tax incentives haven’t brought prosperity to Puerto Rico in the past. They’ve brought greater prosperity to large corporations willing to use them to shelter profits and avoid paying taxes. Working toward tax law that will provide incentives to create jobs in Puerto Rico will be more beneficial than working to recapture an illusion from the past.